Newsletter | October 2018

THE SPREAD BETWEEN 10- YEAR ITALIAN DEBT AND BUNDS REACHES 3%

7.2% THE S&P 500’S BEST QUARTER SINCE 2014

 

Investment perspective 

Global equity markets ended September with modest gains following a weak start to the month. For once, Japanese equities were the outperformers while emerging market equities showed some signs of stabilisation, even if ending the month a little lower. A higher appetite for risk was reflected by the rise of the safest sovereign debt yields and a tightening of spreads for high-yield and emerging market bonds (- 38bps on the J.P. Morgan EMBI Global Spread Index). As to be expected in such a context, the Swiss franc and the Japanese yen depreciated against other major currencies.

The 3rd quarter performances of the main regional indices reflect the extent of the outperformance of U.S. equities so far this year. The S&P 500 returned 7.2%, its best quarter since the last quarter of 2013, whereas the Euro Stoxx 50 gained a marginal 0.1% and the MSCI EM lost 2%, in dollar terms. In spite of more expensive valuations, the U.S. equity market has been underpinned by an accelerating economy and the strong growth of earnings. The quarter was also notable for the fact that the broader U.S. market outperformed the mega cap tech stocks which had been leading the rally for some time.

As fully anticipated, the Federal Reserve raised its benchmark interest rate by 0.25% to 2.25% at its end-September meeting. This third hike in 2018 is widely expected to be followed by another 0.25% hike in December. The most recentcomments by the bank’s chairman, Jerome Powell, suggest that the Fed is far from ending its tightening cycle; Powell pointed to the fact that rates were “a long way from neutral at this point” and cited a “remarkably positive outlook”for the U.S. economy. These remarks have triggered even higher Treasury yields, with the 10-year Treasury yield trading at 3.2% at the time of writing.

The recent flare-up of Italian bond yields reflects investors’ concerns over the Italian budget and the much wider-than-expected deficits projected over the next years. 10-year borrowing costs have risen significantly this year, reaching their highest level since 2014. Considering the high Italian sovereign debt-to- GDP ratio, financial markets are concerned that the Italian government’splans could lead to a confrontation with the European Commission and also ultimately result into an even higher level of debt. This issue represents the biggest risk factor for European assets currently and largely explains the trend of the euro relative to other major currencies.

 

Investment strategy

During the first week of October, the financial markets have been impacted by the jump of U.S. Treasury yields in the wake of strong U.S. macro-economic data and comments from Jerome Powell, signalling a potentially more hawkish stance of the Federal Reserve. Equity markets have reacted quite negatively as they reprice the impact of higher yields on valuations. At this stage, we do not think that equities are close to losing their advantage in terms of relative valuations compared to bonds. More volatility is to be expected, but the equity asset class continues to offer a much more attractive risk/return profile. As good examples, equities listed in Japan and Europe offer price to earnings (P/E) ratios for the next twelve months of 14, a theoretical long term return of 7%, compared to a yield of 0.5% on 10-year Bunds.

As rising yields impact negatively the returns of fixed-income assets, we continue to hold an underweight sovereign debt and investment-grade bonds allocation. Our preferences for the asset class are towards senior secured loans, convertible bonds and flexible strategies with the capacity to actively manage both duration and market risks.

THE SUDDEN RISE OF SOVEREIGN YIELDS SHAKES THE MARKETS

Portfolio Activity/ News

September was a mixed month for the portfolios. The best contribution by far was provided by Japanese equities while EM equities and the trend-following CTA strategy were the worst detractors, the latter mainly due to an extended long position in interest rates. We maintain our positive outlook on Japanese equities due to a combination of attractive valuations, shareholder-friendly measures, low investor positioning and solid earnings’ growth. To a certain extent,the Japanese market also displays a lesser correlation to other developed equity markets.

In September, we took the decision to redeem a European Credit Fund because of the fund’s decreasing size of assets.This exit, for a risk management purpose, is unfortunately inopportune from an investment perspective. The strategy of the fund included the hedging of duration risk, matching our assessment that sovereign yields should continue to keep on rising gradually. At the portfolios’ level, it is however also important to point out that our overall level of duration risk across the fixed-income exposure is low.

 

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